Index Funds are Getting More Dangerous — What’s the Alternative?

The stock market is going crazy. The S&P 500 P/E ratio is at 42 and rising (the historical average is around 15). The Schiller P/E ratio (based on inflation-adjusted earnings over the last ten years) is at 37.

These numbers indicate that the stock market is overbought. Demand for ownership in profitable companies far exceeds supply, so prices of stocks go up. While inflation is contained for the price of milk, inflation is very much NOT contained for assets that interest the rich. Stocks, bonds, crypto, NFTs, etc.

For decades, parking the majority of your savings in a low-cost ETF that tracked the S&P 500 (like VOO or SPY) was the play to make. This strategy has consistently outperformed most mutual funds, hedge funds, and individual stock-picking investors.

But we may be reaching the end game for passive ETF investing. Hedge fundie Michael Burry (played by Christian Bale in The Big Short) has warned about the risks of ETF investing. Passive investing eliminates price discovery. In other words, the S&P 500 includes some extremely overvalued stinkers, with P/E ratios in the hundreds or even thousands. P/E isn’t the only important metric when evaluating the price of a stock, but it’s a risky one to entirely ignore.

Burry also raises concerns about liquidity. All is well when money is flowing into ETFs, but what happens when money flows out? As Burry said, “The theater keeps getting more crowded, but the exit door is the same as it always was.”

So what are we supposed to do with our life savings (if we’re fortunate enough to have any)? Keep it all in cash, and lose to inflation every year? Buy lumps of valuable metals and squirrel them away in a safe deposit box? All well and good until Elon Musk brings home a gold-nugget asteroid and the price plummets. Buy Bitcoin? Bitcoin is just as inflated as everything else, being an asset of limited supply that interests the rich.

Do Your Own Damn Research

Like most things in life, there’s no getting around the work. Passive investing is just too easy.

The alternative to ETF investing is to learn how to evaluate equities and spend some time doing so.

This doesn’t mean to ignore dollar-cost averaging, which should still be the foundational strategy of your investment plan. But when determining which market sectors to dollar-cost-average into (bonds, equities, real-estate, etc.), your equities sector shouldn’t consist entirely of passively managed ETFs. Instead, allocate a sizeable percentage to companies that you have researched yourself, and purchase those stocks individually.

When evaluating which companies to invest in, consider some of the following criteria:

• You use the products and/or services of the company yourself
• The name of the company is widely recognizable
• The P/E ratio is low compared to its competitors
• The P/E ratio is low compared to the S&P 500 average
• You can imagine happily owning a part of the company for 10+ years
• The products and/or services the company provides are relevant and will be relevant in the future

Not every investment needs to fit every criteria. I bought both Tesla and Spotify years ago before either company had impressive earnings. But I’m also planning on increasing my positions in Intel, Target, and Lockheed-Martin (all having reasonable P/E ratios).

Do your own research and come up with your own criteria. There’s no guarantee you’ll pick winners, but you’ll at least be somewhat protected from the tides that are guaranteed to rock the market as a whole.